Economic analysis

A flabby core makes the Bank of Canada's interest rate decision tough

Even though core inflation is weak, the Bank of Canada believes faster consumer price increases are on the way, but there are serious risks if that forecast is wrong

Bank of Canada Governor Stephen Poloz REUTERS/Edgard Garrido

Bank of Canada Governor Stephen Poloz REUTERS/Edgard Garrido

Remember the “cauliflower crisis” of 2016? Bank of Canada Governor Stephen Poloz does. It’s stamped in his memory as an excellent example of how the press makes his job difficult.

“Every individual has a different personalized inflation rate, and it is often enhanced by media attention,” Poloz said during testimony at the Senate Banking Committee in April. “You remember last year it was all about the $9 cauliflower, but this year there were no articles about the 69-cent cauliflower. That is the way it is. Now the articles are about expensive gas, but two months ago there were no articles about the inexpensive gas. That is just life. We try to see through those things and these measures help us do that.”

Scott Tannas, a Conservative from Alberta, had asked Poloz to explain the difference between inflation and core inflation. The “measures” to which Poloz refers above are the three gauges of core inflation the central bank adopted last autumn to give it better view on where prices are headed.

That’s important. The central bank’s only real job is to keep inflation at about two percent. Spikes in vegetable and gasoline prices make that job difficult, as they push the Consumer Price Index into the red. Over-the-top coverage of those spikes complicate matters by creating an impression that inflation is rampant. The core measures calm things down. They exclude the most volatile prices, leaving a truer reading of the trend. Since it can take as long as two years for an interest-rate change to affect prices, the central bank relies on the core gauges to guide it to target: monthly increases in the CPI of two percent—give or take—from a year earlier.

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So: True, no articles about 69-cent cauliflower. But that’s at least in part because those of us who get paid to write about such things have been conditioned to treat inflation as a non-story. Frankly, Tannas wasted his question back in April. The Bank of Canada was all about patchy exports, weak business investment, and record levels of household debt. The message: the economy was so weak there was no reason to worry about prices getting out of control.

If Poloz was correct, and the media only care about prices when they spike to absurd levels, then let me suggest that some us are about to make up for it by working overtime to explain why the Bank of Canada wants to raise interest rates even though core inflation is trending away from the two-per-cent target. It has its reasons, but those reasons aren’t universally accepted. The question that the Bank of Canada must answer definitively when it publishes its next economic outlook on July 12: Why the sudden rush to raise interest rates?

Data released by Statistics Canada on June 23 put the average of the central bank’s three core inflation measures at 1.3 percent; on their own, they form an argument for lower interest rates, not higher.

inflation chart

Weak inflation tends to correspond with subdued demand and excess capacity, and therefore lacklustre economic growth. Not so long ago, Bank of Canada officials were expressing concern that wages were barely growing and that total hours worked hadn’t changed much, even though the economy was adding jobs. Both were legitimate concerns, and there has been no new evidence to suggest either dynamic has changed markedly.

To this, a new wrinkle: international oil prices have plunged almost 20 percent in the past month, dropping below US$43. That’s lower than the prevailing price in 2015, when the Bank of Canada dropped its policy rate to 0.5 percent to counter the blow from the collapse of crude prices. “Lower oil prices are a serious spanner in the works for the Canadian economy,” said Douglas Porter, chief economist at BMO Capital Markets in Toronto. “At the very least, one would suppose that the [central] bank would want to ensure that oil prices are not on their way even lower before pulling the trigger on the first rate hike since 2010.”

One of the reasons Senior Deputy Governor Carolyn Wilkins gave for the central bank’s tilt towards favouring higher interest rates was that the emergency cuts of 2015 appeared to have done their work. Alberta added 41,400 jobs between July 2016, when employment stopped falling, and May of this year, according to StatsCan’s most recent figures. (Alberta lost 59,100 jobs between January 2015 and the trough in July.) Oil prices were around $50 this spring, and a prolonged deviation from that level likely would affect confidence and investment in the oil patch. At the same time, the current drop won’t have the same impact on the broader economy because the oil industry is smaller now. This time, it’s possible the health of the oil industry may not supersede the central bank’s constant worry about losing its grip on inflation.

READ MORE: The Bank of Canada interest rate decision shows Sunny Stephen is back

The shift in the central bank’s tone was dramatic. Bay Street went from assuming the next interest-rate increase would come sometime in 2018 to betting the Bank of Canada could opt to move as early as July. The bets for an earlier shift receded after the latest inflation numbers, but there now is a consensus the Bank of Canada will raise its benchmark interest rate by a quarter point in the autumn, probably October.

Wilkins alluded to why the central bank is unbothered by core inflation. The current readings are “consistent with lagged effects of excess supply in past quarters,” she said. In other words, what we are seeing now fits with the pattern the Bank of Canada has observed over time. Therefore, because the economy has been rolling since at least the middle of last year, upward pressure on inflation must be building. Wilkins reminded her audience that there’s an art to monetary policy: since it takes so long for a change in policy to actually affect economic conditions, central bankers must anticipate. Since almost all of the data suggest inflation is coming, the Bank of Canada is getting ready to act, even if the price data themselves imply the economy still is limping.

READ MORE: Pressure is growing for the Bank of Canada to raise interest rates

Other central banks face similar conditions, and are coming to the same conclusions as the Bank of Canada. In the United States, the Federal Reserve raised its benchmark rate for the second time this year on June 14, even though core inflation remains worryingly slow. The Fed’s resolve to push borrowing costs higher is being resisted by a group of prominent economists that includes Nobel laureate Joseph Stiglitz and Narayana Kocherlakota, who until December 2015 helped set U.S. monetary policy as president of the Federal Reserve Bank of Minnesota. The group wants the Fed to consider raising its inflation target from two percent, and worry less about containing prices until the core actually starts to heat.

The Bank of Canada looked at raising its target last year and decided against it. That decision demonstrated the central bank’s commitment to tethering inflation. It is important to keep in mind that even if Poloz opted to increase interest rates next month, or later this year, the rate still would be an incredibly low 0.75 percent. (Central banks tend to change policy in quarter-point increments.) That probably would be fine, except the central bank has put such an emphasis on core inflation over the years.

And there is nothing obvious in the core measures that suggest higher interest rates are necessary. That matters, because if the Bank of Canada moves too soon and chokes growth, Poloz could be dealing with a crisis far more consequential than $9 cauliflower.